Dividend policy, financial leverage and ownership structure: Empirical evidence from Vietnam

We examine the impact of leverage and state and foreign ownership structure on dividend payout policy of non-financial listed firms on both Ho Chi Minh and Hanoi Stock Exchange of Vietnam from 2010-2015. Our results suggest that firm with high level of debt tend to pay less dividend due to their financial constrain.

DIVIDEND POLICY, FINANCIAL LEVERAGE AND OWNERSHIP

STRUCTURE: EMPIRICAL EVIDENCE FROM VIETNAM

Nguyen Do Quyen1 & Tran Thi Minh Tram2

Abstract:

We examine the impact of leverage and state and foreign ownership structure on dividend payout policy of non-financial listed firms on both Ho Chi Minh and Hanoi Stock Exchange of Vietnam from 2010-2015 Our results suggest that firm with high level

of debt tend to pay less dividend due to their financial constrain Moreover, dividends are used as a signal of good performance to investors Thus, firms tend to keep stable dividend policy over time In addition, firms with higher portion of shares owned by the government are more likely to pay out more dividends Meanwhile, foreign investors are found to have power in monitoring managers so they do not have to use dividend policy

as the tool to reduce the free cash flow problem

JEL codes: G32, G34

Keywords: Dividend payout, financial leverage, ownership structure

Date of receipt: 29 th Nov 2016; Date of revision: 25 th December 2016; Date pf approval:

in which agency problems exist, self-serving managers divert free cash flows to benefit themselves at the expense of shareholders Various mechanisms have been proposed as

potential solutions to this free cash flow problem and dividend payout policy, financial leverage and ownership structure are the most three significant ones

Several studies consider dividend payment as a mechanism to resolve the conflict between managers and shareholders since the payment or non-payment of dividends causes the firms to undergo a third-party audit, which results in lower agency costs (Jensen & Meckling, 1976 and Jensen,1986) Financial leverage also serves as a monitoring tool to reduce agency problems (Ross, 1977 and Stulz, 1990) because firms may face the risk of bankruptcy if managers fail to meet their debt obligations In addition, the agency theory implies that ownership structure can affect the dividend payout policy because dividend can be used as a tool to reduce the agency problem and information asymmetry For instant, Kevin et al (2012) found that the portion of shares held by foreign investor had an inverse relationship with cash dividend They imply that foreign investors can monitor the managers, thus, they do not need a tool as dividend payout for monitoring purpose On the contrary, the portion of shares held by foreign investors is found to have a positive relationship with the dividend payout policy (Baba, 2009) He argues that when foreign investors do not possess enough power and ability to monitor the managers, they tend to use dividend policy as the way to reduce the free cash flow problem

In Vietnam, although dividend policy has been studied by several researchers, most of these studies only focused on examining the determinants of dividend policy No research has examined the dividend policy as a mechanism to control the free cash flow problem of firms and whether dividend policy, financial leverage and ownership structure play as substitutes or complements in reducing free cash flow problem Therefore, the first objective of this research is to examine the dividend policy of Vietnamese firms as a mechanism in controlling the free cash flow problem In addition, this study examines other two mechanisms such as leverage and ownership structure as tools managing free cash flow problems Finally, this study investigates whether dividends, debt and ownership are complement mechanisms in reducing agency costs of free-cash-flow

The data used in this research is collected from Stoxplus database including non-financial listed companies on Ho Chi Minh Stock Exchange (HOSE) and Hanoi Stock Exchange (HNX) of Vietnam The research period covers from 2010 to 2015 The final sample consists of 3699 firm-year observations from 622 listed firms

Using panel data, our study shows evidence that firms with the higher use of debt tend to pay less dividend to shareholders This is because they need to retain net income to meet their debt obligations In addition, firms, which have a great number of shares held by the government tend to pay out more dividends and follow a stable dividend policy On the contrary, foreign investors seem to have power in monitoring managers Therefore, foreign investors do not rely on dividend as a tool to control the free cash flow problem

The rest of the paper is organized as follows Section 2 presents the literature review about dividend theories and summarizes the previous studies about the determinants of the dividend Section 3 describes the data collection and model specification Section 4 discusses the research findings and presents the robustness tests and results Finally, Section 5 presents conclusions, recommendations and the limitation of this study

2 Literature review

2.1 Dividend policy and financial leverage

Financial leverage involves rising of funds from outsource It is the degree to which a company uses fixed-income securities such as debt and preferred equity The more debt financing a company uses, the higher its financial leverage No doubt that firm using debt financing tends to generate high profit on one hand but also subject to higher obligation

to outsiders on other hand The level of risk to which firms are exposed with mixed capital structure is too high because there is always possibility that firm may not be in position to cover its fixed financial cost in coming future time

A survey on CEOs and managers about the determinants of their dividend decision making show that capital structure has influence on dividend policy (Baker, Veit & Powell, 2001) Those companies which have employed leverage in their capital structure

are more conservative and maintain decreasing trend of dividend payout (Warne & Insan 2011) Since firms with high debt are more likely to be financially constrained and should

be less able to pay dividends, a negative relationship between financial leverage and dividend payout policy is expected It is explained that firms with a high level of debt prefer to cut dividends, voluntarily or under creditors’ pressure, to maintain cash needed

to fulfill their obligations toward corporate debt-holders (Higgins (1972) and McCabe (1979), Rozeff (1982), Agrawal & Jayaraman 1994; Faccio, Lang & Young 2001, Afza

& Hammad 2011) This argument is parallel to the arguments of Al-Malkawi (2007), Patra et al (2012) and Al-Najjar (2009) In addition, the increase in firms’ riskiness due

to the use of more debt raises their external financing costs (i.e interest rate) and makes them more dependent on retained earnings Therefore, financial leverage is negatively related to dividend payouts (Al-Twaijry, 2007; Crutchley & Hansen, 1989)

Another strand of literature argue that debt is another mechanism used to reduce the agency costs of free cash flow As stated above, Jensen and Meckling (1976) gave agency theory which advocates conflict of interest between investors and managers Managers pursue their own benefits by taking financial decisions and disregard the interests of investors This conflict leads to the agency costs like monitoring cost and bankruptcy cost Rozeff (1982), Easterbrook (1984) and Bhaduri (2002) gave arguments that both dividend payments and debt are used to reduce more cash flows under the supervision of management so both can be used to reduce agency costs Regarding debt, it allows creditors to have more control and monitoring power over the managers who are under pressure to meet debt obligations by improving organizational efficiency and eliminating negative NPV projects (Agrawal & Knoeber, 1996; Fleming, Heaney & McCosker, 2005; Jensen & Meckling, 1986, Stulz, 1988) In fact, debt can substitute for dividends in reducing information asymmetry and agency problems Therefore, if the signaling power

of dividends is limited in firms with a high level of debts, these firms will have less incentive to pay dividends in comparison to less levered firms (Imad, 2016)

In the study of Al-Kuwari (2009), he also found the strong negative relationship between leverage ratio and dividend payout ratio The reason for this negative relationship is that

highly levered firms carry a large burden of transaction costs from external financing, hence, firm need to maintain their internal sources of fund to meet their obligations However, Ayub (2005) reasoned that there is a probability that debt has no effect on the dividend policy in the countries that the public debt market is not well organized Aasia (2011) when examining the relationship between financial leverage on the dividend policy also pointed out that debt ratio of the company is not significantly impacting on the dividend policy of the firm

2.2 Dividend policy and ownership structure

The agency theory implies that ownership structure can affect the dividend payout policy because dividend can be used as a tool to reduce the agency problem and information asymmetry Many empirical studies pointed out there were various trends in dividend policy among companies with different ownership structure Rozeff (1982) shows that dividend payout is negatively related to the percentage of stock held by insiders Furthermore, he finds that outside shareholders demand a higher dividend payout if they own a higher fraction of the common equity and if their ownership is more disperse

Kevin et al (2012) found that the portion of shares held by foreign investor in China had

an inverse relationship with cash dividend They imply that foreign investors can monitor the managers, thus, they do not need a tool as dividend payout for monitoring purpose

On the contrary, Baba (2009) indicated that the portion of shares held by foreign investors had a positive relationship with the dividend payout policy The author argued that when foreign investors did not possess enough power and ability to monitor the managers, they tend to use dividend policy as the way to reduce the free cash flow problem Warrad et al., (2012) study the relationship between ownership structure and dividend payout policy for the Jordanian industrial firm Their findings reveal no relationship between private ownership, government ownership, foreign ownership structure and the dividends policy However, their results show positive and significant relationship between foreign ownership and dividend payout policy

In addition, Kevin et al (2012) highlighted that there is a positive relationship between the portion shares held by government and the dividend payout ratio They also added that those firms that have major shares held by the government tend to have a stable dividend policy and a high payout ratio This was also documented by Al-Kuwari (2009) who found that government ownership positively impact on the dividend policy Al-Malkawi (2007) also suggests that the proportion of stocks held by insiders and state ownership significantly affect the number of dividends paid Firms with optimum capital structure are able to pay high dividends in comparison with other companies

It would be interesting to examine the ownership structure as a determinant of firms’ propensity to pay dividend policy in Vietnam as the government outweighs foreign investors in firms’ ownership structure The results of Ramli (2010) suggest that controlling shareholders does influence the dividend policy Most Vietnamese-listed firms were privatized from state-owned enterprises and the government is generally a major shareholder after the firms go public Managers are delegated to act on behalf of government Thus, it is expected that managers of these firms will act on the interest of the controlling shareholders, i.e the government

In the research about the relationship between ownership structure and dividend policy in Vietnam, Ly and Bay (2015) found a positive relationship among the portion of shares held by foreign investors and government and dividend payout policy

2.3 Dividend policy and other control variables

2.3.1 Firm size

Firm size is one of the most important factors that affects dividend policy The life-cycle theory explains that large and mature firms which have high free cash flow tend to pay dividends more often than small ones A great number of studies investigated the relation between distributed cash dividends and the size of the firm but no consensus was achieved (Baker et al., 2007; Jakob & Johannes, 2008)

Jensen and Meckling (1976) argued that managers have greater control over larger firms where ownership is more dispersed and shareholders have low incentive and ability to monitor As a substitute solution to agency problem, a high dividend payout ratio would help these firms send positive signals (Lloyd, Jahera & Page 1985; Sawicki, 2005)

Al-Kuwari (2009) and a growing number of other studies (Eddy & Seifert, 1988; Jensen, Solberg & Zorn, 1992; Redding, 1997; Holder, Langrehr & Hexter, 1998; Al-Malkawi, 2007; Manos, 2002; Mollah, Keasey & Short, 2002) found that firm size was positively related to dividend payout as large firms were easier to access capital markets, and had the ability to raise funds with lower issuance costs for external financing Other studies show that small firms pay low dividend because of the high transaction cost they must bear if they need to raise fund externally (Holder, Langrehr & Hexter 1998; Behr & Guttler, 2007) This inaccessibility and high cost of external financing limit small firms’ ability to pay dividends and make them more inclined to retain these funds to finance their future growth

Several studies confirm a negative relationship between dividend payout ratio and firm size For example, Talat (2010) and Hafeez Admed (2012) found that large-sized firms prefer investing in their assets to paying dividends to their shareholders whereas, small companies try to improve their ability to raise funds by paying dividends to accumulate required sum of money from issuance of equity shares at better price It is argued that the bigger the size of the firm, the greater the publicly available information about the firm

is, which leads to the lower of the information asymmetry (Eddy & Seifert, 1988)

2.3.2 Growth opportunities

The signaling theory predicts a positive relation between dividend payout and subsequent investment growth as dividend payout is the reflection of firm’s future prospect A survey conducted on Canadian managers also found that investing, financing and dividends decision should be consistent and dependent on each other (Baker, Dutta & Saadi, 2008) Partington (1983) argued that a firm’s motivation to pay dividends highly depended on its investment and growth opportunities

On the other hand, according to the life-cycle theory, slow or non-growth firms tend to pay high dividends at the mature stage, while small and medium firms with huge growth opportunities keep a high level of retained earnings to reinvest As a result, growth opportunities have negative impacts on the dividend payout policy This hypothesis is supported by various studies (see Alli, Qayyum & Ramirez, 1993; Kanie & Bacon, 2005; Baker & Powell, 2012 and Imad, 2016)

However, it is argued that the negative relationship is only valid in countries with strong legal protection of shareholders If the shareholders feel insecure and doubtful about their rights to share the firm’s future profits, they will prefer to receive current earnings rather than receive capital gain in the future (La Porta et al., 2000) They will put pressure on the firm to pay dividends, regardless of the growth opportunities available

2.3.3 Profitability

The free cash flow hypothesis indicated that profitability has a positive relation with dividend payout ratio of the firms Empirical studies also document a consistent positive link between profitability and dividend payouts (Jensen, Solberg & Zorn, 1992; Fama & French, 2000; Baker & Jabbouri, 2016) Nevertheless, according to Glen et al (1995), dividend policies vary between developed and developing countries, and with the same profitability, there are also differences between dividend payout in countries with strong legal protection for shareholders and those in countries without (Wang et al, 2002; La Porta et al., 2000; Pandey, 2001; Al-Kuwari, 2007; Al-Malkawi, 2007)

However, the research about the determinants of dividend policy of Polish listed companies showed evidence that there is a significant negative relationship between the profitability of the firm (ROE) and dividend payout ratio (DPO) This can be explained that Polish companies use their profits as capital sources and therefore, are less likely to pay dividend This difference may stem from the characteristic of the country itself as Poland is a developed country which has a well-organized stock market and a strong legal protection for shareholders

In Vietnam, there are many studies show that firms’ profitability has positive relationship with dividend payout ratio Ngoc and Cuong (2014) revealed that profitability (measured

as ROA) has positive impact on the dividend decision with 1% level of significance Profitability can be measured as return on assets (ROA) or return on equity (ROE) This study will use ROE as a proxy for profitability as it reveals the lucrativeness of

companies by comparing its net income to its average shareholders’ equity

2.3.4 Liquidity

Liquidity measures the ease at which an individual or company can meet their financial obligations with the liquid assets available to them There are several ratios that express accounting liquidity, but in this research, we use the current ratio as a proxy for the liquidity of the companies

Liquidity is also perceived as an important factor that affects firms’ propensity to pay dividends With a shortage of cash, dividend will not be paid even if the income statement, based on the accrual basis of accounting, reflects a decent profitability Prior studies reported that corporate dividend policy is highly dependent on the firm’s cash position rather than earnings (Anil & Kapoor, 2008; DeAngelo, DeAngelo & Skinner, 2004) Using a sample of industrial firms in New York Stock Exchange and American Stock Exchange, Deshmukh (2003) documents a positive relationship between dividend payout ratio and cash position Moreover, in a recent research of Japanese firms, Kato et

al (2002) conclude that changes in dividend policy are mainly due to alternations in

firms’ liquidity

2.3.5 Past dividend

Lintner (1956) surveyed 28 managers in the United States and concluded that past dividend is a key factor that influences dividend policy He pointed out that US firms largely pursued a stable dividend payout ratio Managers are reluctant to cut cash dividend as it will have negative impacts on the trust of investors and only raise the dividend payout ratio if there are positive and potential prospects Recently, research has

provided substantial evidence that a stable dividend policy, consistent with smoothed dividends per share, is more common in developed countries (Chateau, 1979; Leithner & Zimmermann, 1993) Various studies that tested Lintner’s findings in different markets and over many periods endorse this finding and conclude that past payment affected current dividends (Farrelly, Baker & Edelman, 1986; Baker, Veit & Powell, 2001)

However, several studies show that in developing markets, current dividend payment is independent from its historical pattern and the smoothing effect is less apparent Since current dividend is based mostly on current profitability, the dividend payment is unstable over the years (Glen et al., 1995; Wang et al., 2002; Adaoglu, 2000)

In Vietnam, although the stock market is still developing, the research in firms listed in

Ho Chi Minh Stock Exchange showed that past dividend has a positive relationship with dividend payout policy (Ngoc & Cuong, 2014; Ly & Bay, 2015) These results are

consistent with Lintner (1956)

2.3.6 Free cash flow

Free cash flow represents the cash which is available for firms to generate after laying out the required money to maintain or expand their asset bases

In the early stage, free cash flow was considered as an important factor influencing the reason why firm had to pay dividends Jensen & Meckling (1986) suggested that dividend was used to mitigate agency cost of free cash flow In their seminal work on the free cash flow hypothesis, the agency problem between insiders and minority shareholders increases as the level of free cash flow increases In an attempt to serve their goals, managers spend excessive cash on projects with negative present values, which decreases shareholders’ wealth Several studies demonstrate that paying high dividends can be used

to lessen agency costs and mitigate information asymmetry problems through the reduction of discretion funds that could be expensed on value-destroying projects (Imad 2016) For instance, using a sample of large and medium corporations in Sweden, Gustav and Gairatjon (2008) found that free cash flow has a positive relationship with dividend

policy Sawicki (2008) showed that using free cash flow to pay dividends was an efficient tool to build or improve the firm’s reputation in the emerging countries since the firms paying dividend was less risky and could lower agency problems

However, Imad (2016) showed that free cash flow had a surprisingly negative relationship with dividend payout policy He argued that in the context of emerging countries, where markets are characterized by the absence of corporate governance mechanisms, high information asymmetry, weak legal institutions, and managerial expropriation of shareholders, dividend payments are expected to increase with the decrease of free cash flow

2.3.7 Volatility

Pruitt and Gitman (1991) in their study observed that risk is also a strong determining factor of a firm’s dividend policy They argued that a firm that has relatively stable earnings is more likely to pay a higher percentage of its earnings than firm with fluctuating earnings In other studies, Rozeff (1982), Lloyd et al., (1985) and Colins et al., (1996), a statistically significant negative relationship was observed to exist between beta and dividend payout These findings further suggest that firms having higher level of market risk will payout dividends at lower rate

Cash flow is usually considered as an important indicator of a firm's financial health The high volatility of cash flow is associated with greater market risks and higher operation costs The manager’s dividend policy should consider the expected cash flow and its volatility, which indicate the ability of a firm to pay out current or future dividends Two theories have been advocated to explain the relationship between expected cash flow volatility and dividend payout: information signaling theory and agency cost theory The information signaling theory and agency cost theory provide contrasting explanations between dividend payout and future cash flow volatility The information signaling theory predicts that dividend payout should be lower when future cash flow is more volatile The agency cost theory predicts that firms with more volatile cash flows would pay out a greater proportion of their cash flows as dividends Empirical evidence

supporting the agency cost explanations can be found from Rozeff (1982), Dempsey and Laber (1992), and Wang, Erickson and Gau (1993)

However, many studies (Beaver, Kettler and Scholes, 1970; Miller and Scholes, 1982; Rozeff, 1982 and Keim, 1985) find that firms with higher systematic risk coefficients (betas) offer lower dividend yields Eades (1982) and Alli, Khan and Ramires (1993) examine the relations between total equity return volatility and dividend yields, with mixed results Eades finds that dividend yield is negatively related to both total contemporaneous volatility and residual risk, while Alli, Khan and Ramires fail to find a significant relation Bradley et al (1998) explored the role of expected cash flow volatility as a determinant of dividend policy both theoretically and empirically and found that payout ratio is lower for firms with higher expected cash flow volatility

3 Data collection and model specification

3.1 Data collection

The data used in this study was collected from StoxPlus database including non-financial listed firms on Hanoi and Ho Chi Minh Stock Exchanges of Vietnam from 2010 to 2015 Banks and financial institutions were excluded from this analysis due to their special financial structures, accounting methods and governance The sample includes both dividend and non-dividend paying firms since the exclusion of the non-dividend paying firms from the analysis may lead to a selection bias The final sample consists of 3699 firm-year observations from 622 listed firms during the period of 2010 to 2015

3.2 Variable construction

Dependent and independent variables used in this study are constructed as in the Table 1

(the following page)

Table 1: Variable construction and supporting theories

theories

Expected sign

(+) / (-)

Financial Leverage

(Leverage)

The agency hypothesis

(-)

Foreign Investors

(Foreign_own)

The agency theory

(+)

Government

(State_own)

The agency theory

(+) / (-)

Profitability

(ROA)

The Signaling theory

(+) / (-)

Liquidity

(Liquidity)

The cycle hypothesis

assets

The agency theory

(-)

Volatility

(VOLA)

(-)

3.3 Model specification

Many studies have pointed out that the disadvantage of using the OLS model in panel data structure is that the OLS model ignores the systematic differences between cross-section units (firm-specific effects) and over time Thus, the regression results may be biased and inaccurate On the other hand, fixed effect (FE) model is a standard approach

to account for unit-specific effects The idea is that each entity has a specific feature that may affect independent variable, the fixed effect model examines this feature to control and separate this, and thus, the regression result reflects the net effects of the independent variable on the dependent variable Moreover, the fixed effect model can solve the problem omitted variable bias Therefore, fixed effect model is used as the main model in this study to examine the relationship between leverage, state and foreign structure and dividend payout ratio The FE model is presented as follows:

Tt are dummy variables for firm- and time-fixed effects, respectively

4 Empirical findings

Table 2 shows us the descriptive statistics of dependent variable and independent variables used in this study The mean value of dividend payout ratio is 79% with the standard deviation of 16.04% This result shows that many firms choose to pay significant amount of dividend to shareholders Under 25 percentiles of the firms do not pay dividends while under 75 percentiles of the firms pay 65% out of net income as dividends to shareholder Thus, most the non-financial listed firms pay out a large amount of total net income as dividends Thus, it is implied that due to the preference to receive dividends as the shareholders’ income, many companies pay out a great number

of dividends to satisfy their shareholders’ demand

4.1 Data analysis and descriptive statistics

Table 2: Descriptive statistics

Past_div 3035 0.83 17.37 0.00 0.34 0.66

The mean value of leverage accounts for 51% of the total assets with the standard deviation of 22% Vietnamese firms seem to use quite high leverage ratio The percentage of state ownership accounts for 24% on average Under 75 percentiles of the firms have 50% of state ownership in their ownership structure Meanwhile, foreign ownership structure accounts for 8% on average with the standard deviation of 12%

The average ROA accounts for 6% With the high level of leverage and the low value of ROA, it seems that firms’ performance is not very efficient However, the average liquidity ratio remains at 3.03 times with a large deviation of 35.55% With such a large deviation, the result shows that some firms may face liquidity problems Free cash flow accounts for 6% on average which is reasonable since dividend payout ratios are significant

4.2 Research results

4.2.1 FE regression results

Table 4 reports the regression results for fixed effect model We document a negative relationship between leverage and dividend payout ratio at 1% level of significance Firms with high debt are more likely to be financially constrained and carry a large burden of transaction costs related to external financing Therefore, firms need to maintain internal fund to meet their obligations and consequently, firms should be less able to pay dividends to their shareholders This finding is consistent with our hypothesis and the study of Crutchley & Hansen (1989), Al-Twaijry (2007) anda Al-Kuwari (2009)

State ownership is found to have positive partial impact on dividend payout ratio which implies that if firms have more higher state ownership, they are likely pay out higher dividend Especially in the country such as Vietnam, in which the government owns a big portion of shares However, our finding is not statistically significant Foreign ownership